Appeals court upholds $1 million FBAR fineA $1 million penalty for failing to disclose a foreign financial account has been upheld by a federal appeals court. The Ninth Circuit rejected the taxpayer’s argument that the penalty was uncon...

Small business taxation, corporate tax rates, and changes to popular deductions are just some of the many complex changes to the Tax Code being debated in Congress. At the time this article was posted, the Senate is expected to approve, along party-lines, a sweeping overhaul of the Tax Code written by Senate Republicans. The House has already approved its tax bill, also along party-lines. If the Senate passes a tax bill, House and Senate conferees will seek to resolve differences between the two bills. Conferees will likely aim to reach an agreement quickly to send a bill to the White House before year-end.

Small business taxation, corporate tax rates, and changes to popular deductions are just some of the many complex changes to the Tax Code being debated in Congress. At the time this article was posted, the Senate is expected to approve, along party-lines, a sweeping overhaul of the Tax Code written by Senate Republicans. The House has already approved its tax bill, also along party-lines. If the Senate passes a tax bill, House and Senate conferees will seek to resolve differences between the two bills. Conferees will likely aim to reach an agreement quickly to send a bill to the White House before year-end.

Not since 1986 has such an extensive re-write of the Tax Code been attempted in Congress. In September, Republicans in Congress unveiled a tax overhaul framework. They followed-up with legislation in November. Almost daily, proposals have been revised as legislation moves through the House and Senate.

Several proposals have generated the most debate. They include:

Repeal of the state and local tax deduction

A new tax regime for pass-through income

Lower corporate tax rate

ACA individual mandate

Medical expense deduction

State and local tax deduction. The House bill repeals the state and local tax deduction but would permit taxpayers to deduct up to $10,000 in property taxes. State and local income taxes, or state and local general sales taxes, would not be deductible. In contrast, the Senate bill repeals the state and local tax deduction with no exception for property taxes.

Pass-through income. Both bills would change how pass-through income is taxed. The proposals are extremely technical, raising questions of how easily small businesses would understand and implement the new rules. The House bill generally taxes pass-through income at a maximum rate of 25 percent. The Senate bill calls for a 17.4 percent deduction. The bills have different definitions of what income would be eligible for the new tax treatment. Another significant difference relates to time. The Senate bill’s deduction would be temporary, expiring after 2025. The House bill is permanent.

Corporate tax rate. The House and Senate bills both lower the corporate tax rate to 20 percent. Again, the difference is time. The Senate bill would kick-in after 2019. The House bill would reduce the corporate tax rate after 2017.

Individual mandate. Individuals who do not have minimum essential health coverage must pay a penalty (known as a shared payment) when they file their tax returns. No payment is due if the individual is exempt from the requirement. The Senate bill – but not the House bill – repeals the individual mandate. Because of Senate rules, the Senate bill does not repeal outright the individual mandate but it makes the amount of the payment $0.

Medical expense deduction. Taxpayers who itemize their deductions, and who met other requirements, may be able to deduct certain medical expenses. According to the IRS, taxpayers deducted approximately $85 billion in medical expenses in 2015. The House bill repeals the medical expense deduction. The Senate bill, in contrast, preserves the deduction.

Other deductions and credits. Both bills make significant changes to some popular credits and deductions, like the child tax credit. The House bill proposes to make these changes permanent. The Senate bill envisions temporary changes, generally expiring after 2025.

These and other proposals touch every individual and business. If a tax bill passes Congress, tax planning in 2018 and beyond will look very different from 2017 and prior years. Please contact our office if you have any questions about tax legislation and tax planning.

As an economic incentive for individuals to save and invest, gains from the sale of capital assets held for at least one year unless offset by losses, as well qualified dividends received during the year, may be taxed at rates lower than ordinary income tax rates. The tax rate on long-term capital gains and qualified dividends for individuals is 20 percent, 15, percent, or 0 percent depending on their income tax bracket.

As an economic incentive for individuals to save and invest, gains from the sale of capital assets held for at least one year unless offset by losses, as well qualified dividends received during the year, may be taxed at rates lower than ordinary income tax rates. The tax rate on long-term capital gains and qualified dividends for individuals is 20 percent, 15 percent, or 0 percent depending on their income tax bracket.

The current zero, 15 percent and 20 percent rates (28 percent for collectibles) on long-term capital gains will not change under tax reform. HR 1, the Tax Cuts and Jobs Creation Act, however, does make provision to integrate these rates into the new tiered ordinary income rate structure. The Senate version, for example, provides that the 15-percent long-term capital gain rate would begin in the case of a joint return or surviving spouse, at the $77,200 income level, and the 20 percent rate begins case of a joint return or surviving spouse, at $479,000. Short-term gains would be taxed at the new, ordinary income tax rates. Year-end tax planning for capital gains –whether or not tax reform legislation passes –should therefore follow many of the time-tested techniques used in the past, with some deference to accelerating some short-term capital gains to 2018.

Where to Start

Year-end planning for capital gains should start with data collection and a review of prior year returns. This includes losses or other carryovers, estimated tax installments, and items that were unusual. Conversations about next year should include review of any plans for significant purchases or dispositions, as well as any possible life cycle plans.

When making investment decisions, economic factors in the market should take priority over tax considerations. Taxpayers should not hold assets simply to avoid paying tax on any gain. Similarly, taxpayers should not sell assets just to take a tax loss if the asset will rise in value. Only after the economic factors are considered, should taxpayers consider the tax consequences.

Capital Gains

Most types of nonbusiness property used for personal or investment reasons, such as stocks and bonds, are capital assets. As noted above, to receive the lower tax rate on capital gains, taxpayers must hold these investments for more than one year. The gain from the sale of capital assets held for one or less are ‘short-term’ capital gains are taxed at ordinary income tax rates. In addition, the long-term capital gain rates do not apply to all types of capital assets. A 28 percent rate applies to long-term gains from collectible and small business stock, while a 25 percent rate applies to unrecaptured Code Sec. 1250 gain realized on the sale of depreciable real property.

Generally, taxpayers must offset their capital gains with capital losses before applying the tax rates. Thus, cashing out stock and bonds with a built-in loss can be a simple means of providing a loss to be taken against income. If capital losses exceed capital gains for the year, individuals are only allowed to deduct up to $3,000 of the losses, whether net long-term or short-term capital gain against ordinary income. Any capital losses above $3,000 must be carried over and deducted in succeeding years.

As a result of the netting of capital gains and losses, taxpayers have an opportunity to minimize their tax liability by timing when the gains and losses occur. For example, a taxpayer could sell capital gain property before the end of the year if they have already realized capital gain losses during the year. Also, if allowable deductions for the year will exceed income, taxpayers should try to avoid realizing any additional capital losses during the year as they would be worthless or have to be carried over to the next year.

“Wash” sales. Taxpayers may want to recognize capital losses for tax purposes on stock or securities without completely abandoning their investment. One technique for maintaining the investment is to sell the stock or security at a loss, and then buy the same stock or security. The ‘wash sale’ rules, however, prevent taxpayers from claiming any loss from these types of transactions if they acquire substantially identical stock or securities within 30 days before or after the sale.

Comment. The wash sale rule can be avoided by simply waiting 31 days before purchasing substantially identical stock or securities. Even if taxpayers violate the time limits of the wash sale rule, the disallowed loss is not lost. Instead, the loss is added to cost of the new stock or securities acquired. Plus, the holding period of the new stock or securities includes the time taxpayers held the stock or securities sold for a loss.

Other Timing Rules

When dealing with capital gains, the greatest flexibility taxpayers have comes from their ability to decide when to sell assets. For example, taxpayers may know they will be in a higher income tax bracket in 2018 that would subject them to a higher capital gains rate. As a result, they could sell investments in 2017 to generate long-term capital gains to take advantage of a lower capital gains rate. In other words, spreading the recognition of income between multiple years may help minimize the total amount of tax paid in those years.

Comment. The zero percent capital gains rate creates a planning opportunity, particularly within intra-family situations. Appreciated property may be gifted to a low-bracket individual, with the gain on a subsequent sale then taxed at a zero rate to the extent that gain on top of other income does not exceed the top of the 15 percent bracket. Certain restrictions must be respected, however, including not contravening the kiddie tax rules, not exceeding the annual gift tax exclusion, and not setting up a structured transaction in which the sale after the gift has been prearranged.

Net Investment Income (NII) Tax

In addition to regular income tax liability, many individuals may be surprised to learn that they may be subject to an additional 3.8 percent tax on net investment income (NII). Recent run ups in the financial markets have increased the need to implement strategies that can avoid or minimize this tax. The NII tax is part of the Affordable Care Act and, therefore, will not be repealed under current tax-reform efforts. At least for 2017, taxpayers with income above the $200,000 threshold ($250,000 for joint filers) should assume that their net capital gains, whether long term or short term, will be subject to the additional 3.8 percent tax.

Information reporting has become a growing part of IRS’s enforcement and compliance strategy. Data matching, or even the inference that the IRS has the data to do so, statistically has increased overall income reporting nine-fold. Use of information returns, either in the form of Forms W-2, 1098s or 1099s, is here to stay, and growing.

Information reporting has become a growing part of IRS’s enforcement and compliance strategy. Data matching, or even the inference that the IRS has the data to do so, statistically has increased overall income reporting nine-fold. Use of information returns, either in the form of Forms W-2, 1098s or 1099s, is here to stay, and growing.

Each year, new information compliance requirements arrive at the start of another filing season. The filing season coming up will be no exception, with or without tax reform. Developing rules for the “sharing economy” as well as relatively new deadlines imposed under the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act), all get vetted again this January. Preparing for those deadlines, especially those rapidly coming up at the end of January, needs to start soon.

Earlier W-2s and 1099s

Under the PATH Act, employers are now required to file their copies of Form W-2, submitted to the Social Security Administration, by January 31. This deadline also applies to certain Forms 1099-MISC reporting nonemployee compensation, such as payments to independent contractors, regardless of whether the returns are filed on paper or electronically. Further, only one 30-day extension to file Form W-2 is now available and this extension is not automatic (for more, see the instructions to Form 8809). Having these Forms W-2 and 1099 in hand earlier at least theoretically makes it easier for the IRS to verify the legitimacy of tax returns and properly issue refunds to eligible taxpayers. But they do make for a busy January in many accounting and compliance departments.

“Gig” or “Sharing” Economy

One major area in need of clarification involves reporting under Code Sec. 6050W, Returns Relating to Payments Made in Settlement of Payment Card and Third-Party Network Transaction. In particular, a tighter definition of a third party payment network (for example, for ride sharing applications) is being called for as necessary to prevent abuse, especially since the de minimis threshold for Form 1099-K reporting under Code Sec. 6050W is high.

Entities that qualify as third-party service organizations (TPSOs) are eligible for de minimis rules that eliminate reporting on otherwise reportable amounts if either the amount paid to any service provider within a year does not exceed $20,000 or the aggregate number of such transactions does not exceed 200. This exception can completely eliminate the obligation on the part of a TPSO to issue Forms 1099-K to many “part-time” payees in such areas as rideshare.

When read with the current Instructions for Form 1099-K, the de minimis rules are being interpreted by some taxpayers as eliminating any further obligation on the part of a TSPO to report at all, including issuing a Form 1099-MISC. Payments for more than $600 for services provided by nonemployees are generally reported to the IRS on a Form 1099-MISC by a payor, with a copy provided to the service provider.However, the instructions to Form 1099-K simply say that TPSOs are required to report on service providers only if the $20,000-or-200-transactions level is reached.

Employee versus Independent Contractor

Generally, employers must withhold income taxes, withhold and pay social security and Medicare taxes, and pay unemployment tax on wages paid to employees. Information reporting to the IRS differs depending upon whether the service provider is an employee or a contractor. Whether a worker is an employee or an independent contractor depends on a number of factors.

The IRS has a Voluntary Classification Settlement Program (VCSP), which operates as an amnesty program for employers that want to reclassify previously misclassified workers. Many employees who have been incorrectly classified as independent contractors by their employers can file Form 8919, Uncollected Social Security and Medicare Tax on Wages, to figure and report the employee's share of uncollected social security and Medicare taxes due on their compensation

Expect More to Come

Former IRS Commissioner Koskinen, who left the IRS this past November, underscored the importance of third-party information reporting recently in discussing the tax gap: “when there is information reporting, such as 1099s, income is only underreported about 7 percent of the time…but that number jumps to 63% for income not subject to any third-party reporting or withholding.” With that kind of return on investment, increasing levels of information reporting seem to be here to stay.

Life insurance proceeds are received tax-free. However, any interest earned on life insurance proceeds, usually referred to as its cash value, is subject to tax. Special rules apply to transfers of ownership in a life insurance policy, accelerated death benefits, and viatical settlements.

Life insurance proceeds are received tax-free. However, any interest earned on life insurance proceeds, usually referred to as its cash value, is subject to tax. Special rules apply to transfers of ownership in a life insurance policy, accelerated death benefits, and viatical settlements.

An insurance policyholder might purchase one of many different types of life insurance covering the life of the insured. Term insurance covers a certain period of time, most often one year. If the insured does not die during the term of coverage, no policy proceeds are paid and the policy lapses. Other types of policies, including ordinary life insurance, whole life insurance, variable life insurance, and universal life insurance, provide insurance (and, often, an investment component) during the insured's life span.

Regardless of the type of policy, the beneficiary pays no tax on the proceeds when the insured dies. However, sometimes, usually due to a delay in paying the policy proceeds, the life insurance company pays the beneficiary interest in addition to proceeds. Any interest paid by the life insurance company must be included in income. The exclusion from gross income applies only to the policy proceeds.

If a policy owner surrenders a life insurance policy in exchange for its cash value, the amount received is not the result of the insured's death. Therefore, it is not tax-free and is considered ordinary income to the policyholder. Only the amounts paid by the policy owner, which are a return of capital, are not taxed. The remainder is subject to tax.

Traditionally, life insurance was intended to provide financial assistance to the insured's survivors. In some cases, however, terminally or chronically ill policyholders may sell the policy to meet their financial needs prior to death. When a policyholder sells the policy back to the insurance company for a percentage of its face value, the proceeds are called "accelerated death benefits."

The policyholder might also sell the policy to a third party for a lump-sum payment. The proceeds are referred to as a "viatical settlement" and the third party is usually a viatical settlement company. The third party becomes the policyholder and beneficiary.

Accelerated death benefits and viatical settlement payments are not paid on account of the death of the insured. However, they may be excluded from income only if the person is diagnosed with a terminal illness (or a chronic illness, but only to cover long-term care expenses).

Life insurance may also be used for tax planning purposes, either in a personal or business setting. For these and other refinements as applied to the general rules, please contact this office for details.

The method and systems by which a taxpayer calculates the amount of income, gains, losses, deductions, and credits and determines when these items must be reported, constitute the taxpayer's method of tax accounting. Although the Tax Code and the regulations authorize the use of several accounting methods, and permit certain combinations of methods, a taxpayer must use the accounting method on the basis of which the taxpayer regularly computes book income. Further, the method must be used consistently and must clearly reflect income.

The method and systems by which a taxpayer calculates the amount of income, gains, losses, deductions, and credits and determines when these items must be reported, constitute the taxpayer's method of tax accounting. Although the Tax Code and the regulations authorize the use of several accounting methods, and permit certain combinations of methods, a taxpayer must use the accounting method on the basis of which the taxpayer regularly computes book income. Further, the method must be used consistently and must clearly reflect income.

A taxpayer's method of accounting includes not only the overall method of accounting, but also the accounting treatment of any item. The taxpayer may not treat a particular item in a manner that differs from the overall method.

After a taxpayer has adopted a particular method of accounting, either as an overall method of accounting or as a method of accounting for a particular material item, any changes in accounting method must first be approved by the IRS. The IRS may exercise its sole discretion in accepting a taxpayer's return as computed under the new method of accounting, unless the taxpayer has properly obtained its prior consent to the change.

A change in accounting method may be requested by a taxpayer or required by the IRS. The IRS usually must approve all changes in methods and may specify conditions for implementing the change. The IRS grants automatic consent to many accounting changes. Catch-up adjustments that prevent items of income and expenses from being omitted or reported twice, thereby avoiding possible post-change distortion of income, may be required.

The IRS has provided procedures for obtaining its consent to a change in accounting method. There are two types of consent—automatic consent and advance (non-automatic) consent. Both types of consent require taxpayers to file a Form 3115, Application for Change in Accounting Method. The advance consent procedures require payment of a user fee. The current IRS List of Automatic Changes is found in Rev. Proc. 2017-30.

As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important federal tax reporting and filing data for individuals, businesses and other taxpayers for the month of December 2017.

As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important federal tax reporting and filing data for individuals, businesses and other taxpayers for the month of December 2017.

Businesses benefit from many tax breaks. If you are in business with the objective of making a profit, you can generally claim all your business deductions. If your deductions exceed your income for the year, you can claim a loss for the year, up to the amount of your income from other activities. Remaining losses can be carried over into other years.

Businesses benefit from many tax breaks. If you are in business with the objective of making a profit, you can generally claim all your business deductions. If your deductions exceed your income for the year, you can claim a loss for the year, up to the amount of your income from other activities. Remaining losses can be carried over into other years.

These are very generous tax breaks and sometimes people establish a business to generate losses. They have no intention of ever earning a profit. Other times, they genuinely hope to earn a profit but never do.

The IRS calls these activities "hobbies." Expenses from these activities are never deductible in excess of any income that is declared earned from them. Recently, the IRS issued a new warning in the form of a Fact Sheet (FS-2007-18) to educate taxpayers about the differences between a for-profit business and a hobby.

No bright line

There's no bright line to distinguish a genuine business with a profit motive from a hobby. Over the years, the IRS and the courts have developed a list of factors to determine if an activity has a profit motive or is a hobby. No one factor is greater than the others and the list is not exhaustive. That means that the IRS and the courts have great leeway in their analyses.

Let's take a quick look at the factors:

How the business is run? Is the activity carried on in a businesslike manner? Do you keep complete and accurate business records and books? Have you changed business operations to increase profits?

Expertise.Do you have the necessary expertise to run the business? If you don't, do you seek help from experts?

Time and effort.Do you spend the time and effort necessary for the business to succeed?

Appreciation. Will business assets appreciate in value over time? A profit motive can exist if gain from the eventual sale of assets, plus any other income, will result in an overall profit even if there's no profit from current operations.

Success with other activities. Have you engaged in similar activities in the past?

History of income or loss. This factor looks to when the losses occurred. Were they in the start-up phase? Maybe they were due to unforeseen circumstances. Losses over a very long period of time could, but not always, indicate a hobby.

Amounts of occasional profits. Are your occasional profits significant when compared to the size of your investment and prior losses?

Financial status of owner.Is the activity your only source of income?

Personal pleasure or recreation. Is your business of a type that is not usually considered to have elements of personal pleasure or recreation?

Your financial status

If the activity is your only source of income, you would think that the IRS would automatically treat it as a for-profit business. That's not true. Every case is different and the IRS and the courts look at all the circumstances.

A few years ago, there was a case in the U.S. Tax Court involving a married couple. The husband owned a house framing business. His income was about $33,000 a year. The wife worked as a secretary in an accounting department of a big corporation. Her income was about $28,000 a year.

Together, they also operated a horse breeding and racing activity. They had no experience in breeding or racing horses. They didn't have the best of luck either. Several of their horses suffered injuries and they were involved in a legal dispute over the ownership of one. They did seek help from experts and also kept good financial records.

The Tax Court looked at all the nine factors. It recognized that the couple had a very modest income from their employment and this factor weighed in their favor. However, some of the other factors went against them, especially the fact that they never made a profit after 16 years and lost nearly $500,000. The court knew that the couple "hoped" to make a profit but hope wasn't enough and the court found their business was not engaged in for a profit.

Presumption

Generally, the IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five years, including the current year. If it appears that the business will not be profitable for some years, you won't be able to come within the presumption of profit motive. You'll have to rely on qualifying under the nine factors.

The IRS has a form on which you can officially elect to have the agency wait until the first five years are up before examining the profitability of your business. While it's generally not necessary to file the form in order to take advantage of the presumption, it's usually a good idea.

Types of businesses

Although the IRS is not limited in the kind of businesses that it can challenge as being hobbies, businesses that look like traditional hobbies generally face a greater chance of IRS scrutiny than other types of businesses. These include horse breeding and racing, "gentlemen farming" and craft businesses operated from the home. There are many court cases about these activities and usually the taxpayers lose.

This is a very complicated area of the tax law and many people, like the secretary and her husband, honestly believe they are operating a for-profit business. But as we've seen, the IRS and the courts can, and often do, determine otherwise.

Don't hesitate to contact us if you have any questions about the differences between a business and a hobby ...and how you can set up your operations to have a better chance of falling on the right side of any argument with the IRS.